My favorite investing anecdote of all comes from Benjamin Graham, whose students became some of the world's greatest investors, including Berkshire Hathaway (NYSE:BRKA) (NYSE:BRKB) CEO Warren Buffett. In his book The Intelligent Investor, which Buffett has proclaimed "by far the best book on investing ever written," Graham relays the story of financier John J. Raskob, who famously said it was possible to generate 26% annualized returns by picking "good common stocks" and reinvesting the dividends. Raskob published his bullish treatise on investing in the August 1929 issue of the Ladies' Home Journal. That's right; two months before the crash that helped bring forth the Great Depression. Oops.

Interestingly, Graham's intent in using the anecdote wasn't to skewer Raskob, though he'd have been justified in doing so. (I mean, really, 26%? Thankfully he didn't use similar assumptions in constructing New York's Empire State Building.) Graham instead chose to focus on what actually happened in the ensuing 20 years. And what he found was remarkable: Had an investor, as prescribed, socked away $15 per month in the 30 stocks of the Dow Jones Industrial Average from August of 1929 to the beginning of 1949, and reinvested the dividends, she would have seen her $3,600 investment grow to more than $8,500. That's an 8% average annual return, despite the fact that the Dow sat near 300 when purchases began, and closed at 177 in 1948.

No wonder Buffett advises investors to reinvest dividends. Over time, it's the cure for investors plagued with poor timing. Investors like, well, me.

Crafty little Caterpillar
It was five years ago next month that I finally convinced my wife to open an IRA. At the time, she was self-employed and able to sock away a good-sized chunk of moolah from her business. Once the funds were in there, I wasted no time investing in stocks. No matter that I didn't yet know what I was doing. I had recently read The Motley Fool Investment Guide. I had just enough knowledge to destroy my wife's investment returns. It wasn't the Fool's fault, of course. It was mine. I misunderstood a strategy called the Foolish Four, which we no longer advocate here. (To learn why read our research results.)

The stocks I picked were among the worst of the Dow at the time: Caterpillar (NYSE:CAT), Eastman Kodak (NYSE:EK) International Paper (NYSE:IP), and SBC Communications (NYSE:SBC). The strategy seemed to work fine until the market fell like a lead balloon in 2001. And then it appeared to not work so well. All of these so-called stalwarts lost ground. Caterpillar was initially among the worst hit. By the time we sold her shares two-and-a-half years later, Caterpillar was trading at $41.50 per share, less than our buy in price of $41.63.

The gift that gave, but could have given so much more
Guess what? My wife never actually lost money on Caterpillar. That's because of dividends. The tractor maker had a healthy payout. After adding in the income, her investment in Caterpillar actually grew by 7.3% as the Dow collapsed by more than 20%. That's solid, but it could have been better. Way better.

That's because we ignored Graham, Buffett, and Raskob. We never reinvested the dividends. Had we bought more with our payouts, we would have:

  • Owned nearly six more shares of Caterpillar stock
  • Yielded 3.6% in income annually on our original investment
  • Earned a total return of 14.2%, or nearly double our actual return.

If only the story ended there. But it gets worse. You see, I hadn't studied Caterpillar's financials. If I had, I would've seen the company managed to keep raising its dividend despite tough times. A rising dividend indicates management confidence, and, according to Motley Fool Income Investor chief analyst Mathew Emmert, is one of the best predictors of improved stock performance. So I should have kept the shares. Had I done that, today we'd be sitting on a total return in excess of 148%. Yeah, I know, it makes me sick, too.

Income investing done right
Painful though it is, this sad tale proves one essential truth: Dividends can be a powerful force when it comes to juicing your portfolio. Reinvested dividends are even better. Like compound interest, they compound gains over time. That's why my strategy with Caterpillar was so poor. I could have achieved an outstanding return by being wiser.

There's really only one acceptable excuse for not reinvesting dividends, and that's when you need the income. Many of our subscribers to Income Investor fit this mold, and so we don't show returns with dividends reinvested. (But even without the compounding effect, Mathew's returns are crushing the market by more than 5% since inception.)

Yet, this really ought to be the exception. After all, failing to reinvest dividends when you don't need the income is a lot like failing to claim your employer's matching funds in your 401k. You're giving away free money. So if you're doing it, stop, take a breath, and consider being a little more like Buffett.

Or, get help from an expert. At Income Investor, Mathew and his team teach all there is to know about dividend investing and offer a slew of market-beating recommendations for subscribers. A 30-day free trial is available to you now and there's zero obligation to buy. Ever.

Motley Fool contributor Tim Beyers used to pay compound interest. Now he earns it. That's why he likes his dividends reinvested, too. Tim didn't own shares in any of the companies mentioned in this story at the time of publication. To see what stocks are in his portfolio check out his Fool profile, which is here . The Motley Fool is investors writing for investors and has a disclosure policy .